Mohammed Tariq & Salman Syed Ali CHALLENGES IN MANAGING LIQUIDITY IN ISLAMIC BANKING ENVIRONMENT Seminar on Liquidity Management in Islamic Financial Institutions Central Bank of UAE, Abu Dahbi; December 10, 2005

Over view Liquidity Issues How it is managed and the consequences What is being done and further developments

Excess of Wet or Dry Liquidity Shortage Assassin of banks Liquidity Surplus Drag on competitiveness

Islamic Banks are likely to be more stable They have profit sharing on both the liability side and asset side

But Islamic banks experience excess liquidity Some have also faced liquidity crisis Many different risks culminate in liquidity risk

LIQUIDITY RISK: Definition Risk of Funding [at appropriate maturities and rates] Risk of Liquidating Assets [in time at reasonable prices]

LIQUIDITY RISK: Sources Incorrect judgment and complacency Unanticipated change in cost of capital Abnormal behavior of financial markets Range of assumptions used Risk activation by secondary sources Break down of payments system Macroeconomic imbalances Contractual forms Financial Infrastructure deficiency

Analysis and Diagnosis

Excess Liquidity is the current norm with Islamic banks  Where to park for short-term?  Use of most Islamic modes requires longer tenor investment, murabaha leads to illiquidity (liquidity risk). This induces banks to hold more liquidity. But the there is cost. This leads to very short-term murabaha  low earnings.  Excess liquidity  Use of commodity murabaha Absence of LoLR facility is also a reason

Examples

High Proportion of Short-Term Int’l Murabaha in Total Murabaha,Bank-A (2002) 26.3 %

High Proportion of Short-Term Int’l Murabaha inTotal Murabaha (Bank-B) % 43.7%

Low Income from Short Term Murabaha (Bank-B) Income from Other Murabaha 81 % Income from Short-term Murabaha 15.1 % Income from Other Murabaha 84.9% Income from Short- term Murabaha 19 %

Approaches to Liquidity Management Asset Side Liquidity Management Liabilities Side Liquidity Management Two Sided Approach Islamic Banks are mostly using Asset Approach to liquidity management Large size banks use two sided approach Approach varies b/w retail and investment banks

Liquidity Management: Current Practices of IBs To cope with Excess Liquidity  Commodity Murabaha  Sukuk Ijarah and Salam  Stock Markets To manage Liquidity Shortage  Reverse Commodity Murabaha  Mixing of deposits  Various types of reserves for confidence building Problems and Issues of these practices

New Ideas: Going Forward Mutual funds Mutual fund of sukuk (LMC) IBs’ local club for mutual cooperation Development of secondary market in sukuk (issues involved: increasing the float, shorter term) Sequence of Funds instead of Demand Deposits

Conclusions What is needed What can be done

Thank You